A monetary policy reaction function describes how a

central bank A central bank, reserve bank, national bank, or monetary authority is an institution that manages the monetary policy of a country or monetary union. In contrast to a commercial bank, a central bank possesses a monopoly on increasing the mo ...

systematically adjusts its

policy instruments Policy is a deliberate system of guidelines to guide decisions and achieve rational outcomes. A policy is a statement of intent and is implemented as a procedure or protocol. Policies are generally adopted by a governance body within an organ ...

in response to changes in economic conditions. This function provides a framework for understanding how central banks make policy decisions based on observable economic indicators.

Examples

The most influential reaction function is the

Taylor rule The Taylor rule is a monetary policy targeting rule. The rule was proposed in 1992 by American economist John B. Taylor for central banks to use to stabilize economic activity by appropriately setting short-term interest rates. The rule considers ...

, developed by economist John Taylor in 1993. The rule provides a systematic formula for setting the

nominal interest rate In finance and economics, the nominal interest rate or nominal rate of interest is the rate of interest stated on a loan or investment, without any adjustments for inflation. Examples of adjustments or fees # An adjustment for inflation (in contr ...

based on four key variables: The deviation of current

inflation rate In economics, inflation is an increase in the average price of goods and services in terms of money. This increase is measured using a price index, typically a consumer price index (CPI). When the general price level rises, each unit of curre ...

from the central bank's target; The current

itself; The equilibrium

real interest rate The real interest rate is the rate of interest an investor, saver or lender receives (or expects to receive) after allowing for inflation. It can be described more formally by the Fisher equation, which states that the real interest rate is appro ...

; and the

output gap The GDP gap or the output gap is the difference between actual GDP or actual output and potential GDP, in an attempt to identify the current economic position over the business cycle. The measure of output gap is largely used in macroeconomic p ...

, measured as the percentage difference between actual

GDP Gross domestic product (GDP) is a monetary measure of the total market value of all the final goods and services produced and rendered in a specific time period by a country or countries. GDP is often used to measure the economic performance o ...

and

potential output In economics, potential output (also referred to as "natural gross domestic product") refers to the highest level of real gross domestic product (potential output) that can be sustained over the long term. Actual output happens in real life while ...

. An alternative formulation of the monetary policy reaction function was proposed by

Ben Bernanke Ben Shalom Bernanke ( ; born December 13, 1953) is an American economist who served as the 14th chairman of the Federal Reserve from 2006 to 2014. After leaving the Federal Reserve, he was appointed a distinguished fellow at the Brookings Insti ...

and

Robert H. Frank Robert Harris Frank (born January 2, 1945) is the Henrietta Johnson Louis Professor of Management Emeritus and a professor of economics at the Cornell Johnson Graduate School of Management at Cornell University. He contributes to the "Economic ...

.Bernanke, Ben, and Frank, Robert. ''Principles of Economics'', 3rd edition. Their simplified version describes a positive relationship between the

and the

, where central banks respond to rising inflation by increasing real interest rates: :r = r* + g(π – π*) where :r = current target real interest rate
:r* = long-run target for the real interest rate
:g = constant term (or the slope of the MPRF)
:π = actual inflation rate
:π* = long-run target for the inflation rate This linear relationship provides a more straightforward framework compared to the multi-variable Taylor rule, though it captures fewer economic factors.

References

{{Central banks Monetary policy